Liquidity is like water. Is water a solid, a liquid, or a gas? Depending on the situation, water can be any or all of the three. When I started my blog, my first serious post was “What is Liquidity?” Given what was about to happen in Shanghai seven days later, and what that would do to liquidity, the post was ahead of its time.

Yesterday I saw two posts on liquidity:

• Liquidity isn’t apple pie
• Is Illiquidity Just Another Word for Uncertainty?

Both had a number of good points, though I like my piece better.  Let me borrow from Peter Bernstein, where he said something to the effect of “Liquidity is the ability to have a do-over.”  In other words, if you make an investment mistake, how much does it cost you to reverse it?

The three aspects of liquidity:

• What sort of premium does it take to get someone to lock into a long-term commitment?
• Slack assets available for deployment into new investments, and
• Bid-ask spreads

are correlated.  When there are few slack assets relative to investment needs, large premiums have to be offered to get investors to lock into a long-term investment, and bid-ask spreads tend to be wide as well.

But let’s consider the flip side of liquidity.  Liquidity is akin to holding a long option.  Rising volatility is the friend of one who has liquidity or a long option.  But, being long an option means someone else is short an option.  Having liquidity means that someone else has to provide cash should you choose to buy something.  If you liquidate shares in a money market fund, cash must come either from new investors in the fund who take your spot, or the fund has to raise liquidity internally, handing you some of the proceeds from not entering into an overnight loan.

Or, consider the bid-ask spread in stocks, or other securities.  When the bid-ask spread is tight, it means that the market maker (or specialist), is comfortable that short-term volatility is low enough, that he will be able to profit from the tight spread on average.  When there is severe uncertainty, as there often is in esoteric fixed income instruments during a panic period, the bid-ask spread disappears, and one is reduced to “price discovery, using a broker who is discreet about your intentions regarding buying or selling.  (My, but I got good at that during 2001-2003.   Ouch.)

I like my definition of liquidity, which is the willingness (price) to enter into or exit fixed commitments.  It covers all three aspects of liquidity, and helps explain why they are usually different manifestations of the same phenomenon.

As for now, versus mid-February 2007, the willingness to enter into fixed commitments has declined markedly, even though it has improved over the last seven weeks.  That is no guarantee that it will continue to improve linearly.  Bear markets have their rallies, and this current rally has been a good one.  It would be rare to have such a short bear market, or one that ended without clearing away most of the prior excess lending problems.  We still have a lot of wood to chop there.

I tried forecasting the non-farm payrolls number when I first came to RealMoney — after all, what other number made as big of a splash? I seemed to do well at it for a while, and then badly, and then I really began to dig in to how the number was calculated. The more I dug into it, the more I concluded that I could not forecast it. Not that it is wrong, made up, whatever. I just could not forecast it, so I gave up.

Not that I like being a quitter, but there are benefits to recognizing reality and respecting it.  I did learn some things along the way, though, and let me explain them:

1) The 12-month change for the seasonally adjusted [SA] and non-seasonally adjusted [NSA] numbers are equal.

2) The seasonal adjustment is more than just an adjustment for seasonality.  There is a distinct annual pattern to the NSA data, and I have done my own seasonal adjustments and they do not reduce that variability nearly as much as the BLS methods which involve ARIMA models.  (As one of my econometrics professors used to say to me, “Practitioners use ARIMA models when they have no idea of what the true model might be.  It’s just a hunt for correlations.”)

In other words, the SA data is not just adjusted for seasonality, but it is smoothed as well.  Now, as an actuary, I can get into smoothing.  We do that all the time when theory would dictate smoothness, as in mortality table construction.  But here the smoothing is opaque to me, and presumes that changes to employment levels happen slowly.  I’m not sure that always holds.

Think of it this way — the SA figures always contain a pad/buffer/fudge factor, whether positive or negative, that gets amortized into future changes in employment.  A particularly large change in the NSA figures will tend to lead to the SA figures changing in the same direction for a little while (or, in some cases, they revise prior months). For what it is worth, I think the pad is small at present.

3) You can’t easily disaggregate the birth/death [B/D] adjustment from the SA figures, because the SA figures come about like this:

• Calculate the raw NSA figure
• Add the B/D adjustment
• perform the seasonal adjustment (and smoothing)

4) The B/D adjustment works sort of like this: estimate the amount of jobs that the economy will add from new businesses that are outside of our survey for the next year.  Add those jobs in using a pattern that reflects our estimate of when businesses add jobs on net.

5) Now, back to the graph at the top of this page.  The blue line is the number of net jobs added over the prior 12 months.  It doesn’t matter whether I use the NSA or SA figures, because over 12 months, they are the same.  The magenta line indicates the number of jobs added by the B/D adjustment over the prior 12 months.

Because I am doing a year-over-year comparison, I escape the problems associated with the seasonal adjustment, and this fairly disaggregates the B/D adjustment.  The yellow line is the proportion of net new jobs coming from the B/D adjustment.  Over the life of the B/D adjustment (since 1/1/2000), the B/D adjustment has made up 82% of all new jobs created.

6) At present, the B/D adjustment is running at an annualized 750-800 thousand jobs per year.  I don’t know if that is right or wrong, but since 2004, it has been near that level.  Recently, non-farm payroll numbers and the B/D adjustment have been declining, but the B/D adjustment has been declining more slowly.   The B/D adjustment accounts for more than 100% of jobs added over the past twelve months.  That’s not necessarily wrong, but the B/D adjustment does move slowly.

7) I’ve tried to be as neutral as possible here.  Two of my favorite bloggers, Dr. Jeff Miller, and Barry Ritholtz, are on opposite sides of this argument.  I put this out as data for discussion; I am not taking a stand because I can’t vet out the estimates of job creation from the birth/death adjustment.  They could be high, low, or just right.  In a slowdown, perhaps they should be off more, but the global economy is still strong, supporting jobs in some cyclical sectors.

1) Desperation and the Dollar. In mid-March, pessimism over the US economy and monetary policy were so thick that people were considering the old Greenspanian rate of 1% Fed funds as possible. Well, times change, at least for now. The orange line above is the 2-year Treasury yield which gives a fair read on expectations of monetary policy, which bottomed in mid-March. It took the Dollar a little longer to move along, but the present course of dollar is up in the short-term (consider the Euro). That doesn’t address the possibilities of a wider lending problem, or the overly aggressive fiscal policies that will be employed by the next President. (Deficits don’t matter, until they are big enough to matter.)

2) I’ve talked about the US Dollar and the five stages of grieving. I think the G7 got to the second stage, anger, in threatening action recently. I think they get a respite from fear because of the bounce in US monetary expectations. My guess is that they would intervene when the Dollar gets to $1.70/Euro. Neither the threats nor the intervention will have much impact in the long run, though. This will only change when foreigners stop buying our bonds, and start buying our goods and services.

3) Another thing that correlates with the shift in expectations of US monetary policy are yields in long government bonds around the world. Surprise, as the anticipated future financing rates rise, the willingness to try to clip a spread off of long bonds declines.

4) So what could replace the Dollar as the global reserve currency? The Euro, maybe? The Yen and Pound are too small, and everything else is smaller still. The Yuan might be ready in 15 years when their financial markets are developed. It takes a long time for the reserve currency to shift.

5) So, why not the Euro? I’m still a skeptic that the EU will hang together without political union. Also, a strong Euro is testing the monetary union in places where credit markets are weak, and export markets are weakening because the US is getting more competitive with the weak Dollar. That said a persistently weak dollar raises the incentives for other countries to look for a new reserve currency. Leaving aside the potential instability of the EU (unlikely in the short run) the Euro is probably the best alternative.

6) This piece by Felix Salmon helps point out why why Iceland is the canary in the coal mine. They are the smallest economy with a floating currency. It seems like they are successfully defending their currency at present, at the cost of 15% interest rates.

7) Is the UK economy just a miniature version of the US economy?

• Cutting Central Bank lending rates
• Bailout plans for the banks (and here)
• Many homeowners with negative equity, and all of the problems that brings

8 ) Why is Chinese inflation rising? Loose monetary policy, and an undervalued Yuan, at least versus the Dollar. Now, maybe the Chinese will start buying Euro-denominated bonds, and sell more to the EU than they buy. (Note that I am not the only skeptic on the Euro’s survival.)

9) What of the Gulf States? What will they do with all of the dollars that they have? Along with China, their huge depreciating Dollar reserves are fueling inflation. Personally, if I were in their shoes, I would buy US corporations quietly, perhaps through the purchase of ETFs. But the huge accumulation of dollars threatens to create the same “white elephant” development schemes that they experienced in the early 80s, when the socialist Gulf governments had too many Dollars, and too few places to use them.

10) Inflation is rising in the OECD. This is a “sea change” in terms of economics. Policymakers have enjoyed falling inflation rates for so long that perhaps they aren’t ready for the degree of monetary tightening necessary to squeeze out inflation.

11) Development isn’t easy after a point. It reveals shortages, as India is experiencing in semi-skilled and skilled labor. This will eventually work out, but in the short run, it makes infrastructure and construction projects difficult. Bodies aren’t enough; skills are needed, and many better skilled Indians work abroad, where they can make more.

12) A rice cartel? Everything old is new again. I remember in the 1970s when the US talked about a wheat/corn cartel, in response to the new strength of OPEC. Personally, I don’t think it would be effective. Agriculture is too flexible for cartel-like schemes to work in the intermediate-term. But, let them try. It will be interesting to see what happens.

In my blogging, in my other research and in investing, I gain some degree of comfort from being criticized by both bulls and bears. Worst of all would be no criticism; it would mean that I am not saying much. Criticism from both sides means that I am probably not blindly taking a partisan view, or talking my own book.

Briefly this evening, I want to point out some of the costs of our current monetary policies. Now, some things are going well, and the Fed might want to take some credit.  But the costs are soft costs, ones that are preferable to systemic financial collapse. That said, there are smarter and dumber ways to do bailouts. When I criticized the Bear Stearns bailout, I tried to point out how there have been better ways of doing bailouts from history, and that the Fed should have known this. I understand that the Fed may have felt rushed at the time, leading to a suboptimal decision, but they should be better read on economic history. Bailouts should be very painful for those bailed out, or else others line up for them.

Well, now that there has been one bailout, why not more? Other shaky areas of the economy could use a bailout… student lenders, homedebtors, home lenders, etc. Are they less worthy than Bear Stearns? Ignore the student lenders, because they pose little systemic risk. If housing prices fall another 20%, the systemic risk issues could be severe. Consider there two quotes from the article:

“There is no way to put the genie back in the bottle,” Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. “What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.”

and

Richmond Fed chief Jeffrey Lacker and policy adviser Marvin Goodfriend wrote in a 1999 paper that central bank lending creates ever-expanding expectations. “The rate of incidence of financial distress that calls for central bank lending should tend to increase over time,” they wrote. That “creates a potentially severe moral-hazard problem.”

We’re on that slippery slope now. Should the Fed bend monetary policy even more to compensate for areas of lending where they have inadequate control? To the extent that you believe in central banking, central banks should deal with the big issues, and leave the little ones alone. Lend at a penalty rate during a crisis; don’t try to make things normal. Where there is systemic risk, stand behind the core but not the fringe; defend debt claims, and wipe out equity claims.

Or, consider the second order effects that our monetary policy creates: the weak dollar and the responses that foreign governments must follow: let their export sector wither, or follow US policy down, and accept more inflation. It will take a long time for the US to lose its reserve currency status, but we are on that path. Here’s to the day when we have to borrow in the currencies of oil exporters, or China. (Please no. )

Or, consider the troubles that the states are in, since they have to run balanced budgets, unlike the Federal government, which can borrow in dollars, and inflate the currency as needed. I follow state tax revenues; it is an excellent coincident read on the economy. Well, sales tax revenues are falling. Also, some states are considering one of the “dumbest ideas ever” — pension bonds (borrowing to fund pension plans, relying on clever investing to beat the rate paid on the bonds). New Jersey lost big on their last attempt at pension bonds. Far better to consistently fund municipal pensions through general revenues. For those that have read me before on municipal pensions, their claim to fame is that they make private sector funding look good.

Finally, to end on a less sad note, is Iceland looking better, or , is it just part of an overall bear market rally?  (What of Argentina?)   My guess is the latter, but maybe they have successfully defended their currency. Then again, we can look at Brazil, which is now investment grade on one side (from S&P). Good news follow good policies, and Brazil has been on the right track — they have become a net creditor, unlike the US. Hey, maybe the Real should be a reserve currency.

1) The rating agencies have been running like crazy. They do that when they are behind the curve. Whether it is Moody’s on subprime, or S&P on Alt-A lending, the downgrades are coming in packs. Then there are difficulties with the debts of real estate partnerships, like LandSource Communities Development, which is likely to file for insolvency, together with some residential developers.

2) Now, there have been a few summary pieces on how the rating agencies changed as the housing boom moved on. Here is one from the New York Times, and one from the Wall Street Journal. As I had commented long before in my writings at RealMoney, the rating agencies were co-dependent with those that paid them. That said, it would be hard to construct a system that would not be that way. Buyers don’t have a concentrated interest in ratings. Issuers so.

3) If I were Ambac, I would be doing all that I could to allege fraud on contracts where representations and warranties were not upheld. Ambac is fighting to survive.

4) Mortgage insurers — it is the best of times, if you survive, because you are the almost the only game in town for those wanting to do low down payments, and rates for mortgage insurance are way up. But, it is the worst of times, housing prices are falling, rating agencies are downgrading, and defaults on insured mortgages are rising.

5) Foreclosures:

• An excellent summary and map of foreclosure activity.
• Maryland makes them take a little longer. (The article overstates the lengthening.)
• California is suffering.
• Desperate in Denver.
• Foreclosures and crime are correlated.
• Which leads the FHA to act, and the states to act as well, because Federal efforts are slow.

6) Gotta love OFHEO, which is trying to rein in the GSEs during a lending crisis. Even though they may have traction, I don’t see how they tighten the regulations during a crisis.

7) For that matter, consider the lenders. Countrywide seemed to purposely ignore the creditworthiness of borrowers as they jammed it out the door lent on mortgages. Even with all this, mortgage lenders are complaining that new regulations will make mortgages less affordable. What they mean is that they will issue fewer mortgages, and they will make less profit. Please, let’s stop making it easy for those that can’t afford a home to take the risk of buying one. Higher mortgage rates are bad in the short run, but good in the long run.

8 ) Dr. Jeff reluctantly asks what inning we are in on housing. I understand that it is an overused metric, but it is overused for a reason. Nine is an intuitive number — are we halfway through? Fifth inning. One-quarter? Third. Almost done? Eight or ninth. He also makes a simple request to those of us who opine on the housing slump, to be more definite in what we say, provide more data, and what will be signs that the troubles are turning.

I need to set up some housing recovery googlebots to scan for me, but my guess is that we are in the fifth inning of the troubles. When I get more definitive guesses/answers to the questions, I will post.

9) Delinquencies:

• Lenders, or better, servicers, are struggling with the load.
• That said, the growth in subprime delinquencies is slowing. Perhaps we are going through burnout, where most of those likely to default have done so, and a few incremental defaults remain.
• But home equity loan experience keeps getting worse. (My only surprise there is how slow this has been in arriving.)

10) Home prices continue to fall, and estimates to the nadir (cycle low) range between 0-50%, with 10-20% being the most common.

11) Falling home prices will lead to many more foreclosures in prime loans, and of course Alt-A and subprime. Foreclosures happen when a sale would result in a loss, and a negative life event hits — death, divorce, disaster, disability, and unemployment.

12) Second-order effects:

• Home remodeling expenditures fall
• (Commercial) Architecture Billings index falls. (Does not bode well for commercial real estate.)
• Low new housing sales.
• Tough total sales environment in the SF Bay Area. Sales fall before housing prices, and rise as housing bottoms. (Opinions on that last thought?)
• Allegations of fraud are thick among borrowers and lenders. A lotta smoke, but is there any fire?… Clearly, the servicing system was not designed for this level of failure, so I’m not surprised that things are moving slowly.
• Homeowner vacancy rates are at an all-time high. That should keep the pressure on prices, because there is a lot of competition if you want to sell, and there is a lot of dark supply waiting to emerge if prices get more favorable. Emergence from this set of troubles may be slow, much like a credit crisis in the corporate bond market often feels slow to unwind.

I find it interesting that some former senior people at the Fed are breaking the “code of silence.”  I don’t mean that those that leave the Fed go totally silent, but they are usually supportive of the current Fed if they speak.  Even Greenspan, who pushes his own legacy, is largely supportive of Bernanke.  But with Volcker speaking out, others are emboldened, like Vincent Reinhart.  I don’t know exactly what Reinhart said in his speech yesterday, but I would bet that it is similar to what he wrote here.

Some of his comments are similar to what I wrote in point 1 of this blog post of mine:

1) How to do a bank/financial bailout: a) wipe out common and preferred equity and the subordinated debt (and offer some warrants to the debtholders).  Make the senior debt take a haircut of 50% (and offer warrants), and the bank debt a haircut of 20% (and offer warrants). Capital is offered in exchange for the equity interest, together with some senior financing pari passu with the banks.  If the management and other stakeholders do not like those terms (or something like them), then don’t bail them out.

Now, realize I’m not crazy about “lender of last resort” powers being in the hands of the government, but if we’re going to do that, you may as well do it right, and bail out depositors in full, while having others take modest to large haircuts.  There is no reason why the government/Federal Reserve should bail out common or preferred equityholders, and those that bought risky debt should pay part of the price as well.  This should only be done for institutions where significant contagion effects could affect other financial institutions.  The objective is to create a firewall for depositors, and the rest of the financial system.

There were better ways to achieve the protection of the derivatives market the the Fed wanted to achieve.  Take a page out of the playbook of the insurance regulators that are sweating over the financial guarantors.  Are they worried about the holding companies that own the operating insurers?  No, they are only worried about the operating insurers.  In the same way, the Fed didn’t need to sell off Bear Stearns, and (in a way) backstop the sale.  All they needed to do was say that they would provide credit to the derivatives arm if Bear failed.

Hindsight may be 20/20, but the Fed neglects Bagehot’s rule to lend infinitely at a penalty rate in a crisis.  The penalty has not been there.  Beyond that, Reinhart points to the ways that the Fed is taking credit risk onto its balance sheet, which limits its flexibility.

Can that credit risk have negative impacts on the Fed?  Yes, but maybe those effects aren’t big.  The Fed is a profitable institution.  How profitable?  Who gets the profits?  Well, the US Treasury gets the profits, essentially unifying the Fed with the US government in an economic sense.  From fiscal 2005-2007, the Fed earned $18.1, 21.5, and 28.5 billion respectively.  Any losses from credit risk will diminish what the Fed dividends back to the US Treasury, which will raise borrowing and taxes.  So the impact is minor, in one sense — you can destroy the value of the US Dollar, but the Fed is an arm of the US Government in an economic sense.  It dies only when the US Government dies, or when the US Government eliminates it (hey, it’s happened before in US history).

One thing about Jim Cramer, he is quotable.  Take this short bit from his piece, Graybeards Get It Wrong on Financials.

One of the loudest and most pervasive themes by a lot of the graybeards is that there is still much more pain ahead in the financials.Let me explain why that is wrong. First, the group is down from a year ago. It’s been hammered mercilessly.

More important, every time the stock market rallies is another chance for these companies to refinance.

Remember, as they go up, the companies are in shape to tap the equity market again because those who bought lower are being rewarded, psyching others to take a chance. In fact, other than the monoline insurance faux bailouts, people who pony up are doing pretty well.

Now, he might be right, and me wrong on this point (with my gray beard, though I am younger than he is).  But let me point out what has to go right for his forecast to be correct.

1) The inventory of vacant homes has to start declining.  Still rising for now, another new record.  Beyond that, you have a lot of what I call lurking sellers around, waiting to put more inventory out onto the market, if prices rise a little.  They will have to wait a while, and many will lose patience and sell anyway.  There is still to much debt financing our housing stock, and though most of the subprime shock is gone, much of the shock from other non-subprime ARMs that will reset remains.  Will prices drop from here by 20%?  I think it will be more like 12%, but if it is 20% there will be many more foreclosures, absent some change in foreclosure laws.  Foreclosures happen when a sale would result in a loss, and a negative life event hits — death, divorce, disaster, disability, and unemployment.

2) We still have to reconcile a lot of junk corporate debt issued from 2004-2007, much of which is quite weak.  Credit bear markets don’t end before you take a lot of junk defaults, and we have barely been nicked.  Yes, we have had a sharp rally in credit spreads over the last five weeks, but bear market rallies in credit are typically short, sharp, and common, keeping the shorts/underweighters on their toes.  You typically get several of them before the real turn comes.

3) We have not rationalized a significant amount of the excess synthetic leverage in the derivatives market.  With derivatives for every loser, there is a winner, but the question is how good the confidence in creditworthiness between the major investment banks remains.  Away from that, Wall Street will be less profitable for some time as securitization, and other leveraged businesses will recover slowly.

4) Credit statistics for the US consumer continue to deteriorate — if not the first lien mortgages, look at the stats on home equity loans, auto loans, and credit cards.  All are doing worse.

5) Weakness in the real economy is increasing as a result of consumer stress.  Will real GDP growth remain positive?  I have tended to be more bullish than most here, but the economy is looking weaker.  Let’s watch the next few months of data, and see what wanders in… I don’t see a sharp move down, but measured move into very low growth in 2008.

6) What does the Fed do?  Perhaps they can take a page from Cramer, and look at the progress from private repair of the financial system through equity and debt issuance.  It’s a start, at least.  But the Fed has increasingly encumbered is balance sheet with lower quality paper.  Two issues: a) if there are more lending market crises, the Fed can’t do a lot more — maybe an amount equal to what they have currently done.  b) What happens when they begin to collapse the added leverage?  Okay, so they won’t do it, unless demand goes slack… that still leaves the first issue.  There are limits to the balance sheet of the Fed.

Beyond that, the Fed faces a weak economy, and rising inflation.  Again, what does the Fed do?

7) Much of the inflation pressures are global in nature, and there is increasing unwillingness to buy dollar denominated fixed income assets.  The books have to balance — our current account deficit must be balanced by a capital account surplus; the question is at what level of the dollar do they start buying US goods and services, rather than bonds?

8 ) Oh, almost forgot — more weakness is coming in commercial real estate, and little of that effect has been felt by the investment banks yet.

As a result, I see a need for more capital raising at the investment banks, and more true equity in the capital raised.  Debt can help in the short run, but can leave the bank more vulnerable when losses come.  The investment banks need to delever more, and prepare for more losses arising from junk corporates and loans, housing related securities, and the weak consumer.

The bond market has had quite a shift since the last Fed meeting. What are the common themes?

• Outperformance of credit, especially high yield.
• Return of the carry trade.
• Tax-free Munis have run.
• Underperformance of Treasuries (longer= worse), and foreign bonds, particularly carry trade currencies like the Yen and Swiss Franc.

The willingness to take risks in fixed income has returned, particularly in the last two weeks. I don’t want to tell you that this is a trend that won’t reverse… it might reverse. Remember that bear market rallies tend to be short and sharp, and that the credit bear market in 2000-2002 had several legs. Leg one may be over for this credit bear market, but that doesn’t mean the credit bear market is over; there are still too many unresolved credit issues in housing, builders and investment banks.

Now, to flesh out the changes, I looked at the total returns on 15 major ETFs in different sectors of the bond market. Here are the returns since 3/19:

• HYG — High yield Corporates + 4.47%
• DBV — Carry trade fund +2.83%
• MUB — National Municipals +1.10%
• LQD — Investment Grade Corporates +0.99%
• FXE — Euro currency Trust +0.29%
• BIL — Treasury Bills -.06% (Negative on T-bills?!)
• AGG — Lehman Aggregate -1.03%
• SHY — Short Treasuries -1.18%
• TIP — TIPS ETF -2.85%
• IEI — 3-7 yr Treasuries -3.41%
• FXF — Swiss Franc Currency Trust -3.44%
• BWX — Intl. Gov’t Bond Fund -3.49%
• IEF — 7-10 yr Treasuries -3.74%
• TLT — 20+ Treasuries - 4.87%
• FXY — Yen Currency Trust -5.30%

What a whipping for safe assets. Perhaps the Fed will be happy that they helped engineer the whacking. Then again, the TED spread is still high, and the change might just be a normal shift in sentiment after the panic leading up to the last FOMC meeting. Interesting to see both the return of the carry trade and credit spreads outperforming the move in Treasuries.

For those that follow my sector recommendations, I would be lightening, but not exiting credit positions in the near term. I’m in the midst of considering my other sector recommendations, and will report on this soon. For more on this topic, refer to:

• Its against my programming to call bottoms (and anything by Accrued Interest)
• RIP Bond Rally 2005-2008
• Signs of Improvement in the Credit Markets
• Debt Investors Show Signs Of Relief

Before I close, one large negative area where there is excess supply: preferred stock of financial companies.  There is a lot floating around from balance sheet repair efforts where they didn’t want to dilute the common.  (That’s the next act.)  I would stay away for now, but keep my eyes on selected floating rate trust preferreds, to leg into on the next leg down.

1)  Let’s start out with my forecast.  I’ve given it before, but it has become the conventional wisdom — at the next FOMC meeting at the end of April, the Fed will cut by 25 basis points.  They will make the usual noises about both inflation and economic weakness, as well as difficulties in the financial system, and comment that they have done a lot already — it is time to wait to see the power flow.  The only difficulty is whether we get another blowup in the lending markets that affects the banks.  We could see Fed funds below 2% in that case, but absent another crisis, 2% looks like the low point for this cycle.  Now all that said, I think the odds of another crisis popping up is 50/50.  We aren’t through with the decline in housing prices, and there are a lot of mortgages and home equity loans that will receive their due pain.

2) One interesting sideshow will be how loud the hawks will be opposing a 25 basis point cut.  We have comments from voting members Plosser and Fisher already. Price inflation is a real threat to them, and one that is closer to the Fed’s core mission than protecting the financial system.

3)  Okay, give the Fed some credit regarding the TSLF, which is now almost not needed.  The TAF is another matter — there is continuing demand for credit there.  It will be interesting to see when the Fed will stop the the TSLF, and what happens when they try to unwind the TAF.  As it seems, some banks still need significant liquidity from the TAF.

4) Indeed, if the Fed is lending to investment banks, it should regulate them.  I would prefer they didn’t lend to investment banks, though.  Better they should lend to commercial banks that are negatively affected by investment bank failures, and let the investment banks fail.  After all, there is public interest in the safety of depositary institutions, but I’m not sure that if the investment banks disappeared, and the commercial banks were fine, that the public would care much.  It certainly would teach the investment banks and the investing public a real lesson on overdoing leverage.

5)  Okay, so LIBOR rises after it seems that some bankers have been lowballing the rate in an effort to show that they are not desperate for funds.  Significant?  Yes, the TED spread has widened 12 basis points since then.   I’m sure that borrowers with mortgages that float off LIBOR will be grateful for the scrutiny.

Having been in similar situations in the insurance industry regarding GIC contracts, I’m a little surprised that the BBA doesn’t have some requirement regarding honoring the rate quote up to some number of dollars.  On the other hand, can’t they track actual eurodollar trading the way Fed funds gets done, and then just publish an average rate?

6) Onto the last three points, which are the most controversial.  You know that I think the core rate of inflation is a bogus concept.  If you are trying to smooth the result, better to use a median or a trimmed mean, rather than throwing out classes of data, particularly ones that have had the highest rates of inflation.  Given the inflation that is happening in the rest of the world, I find it difficult to believe that we are the only ones with low inflation, unless it is an artifact of being the global reserve currency.

7) I was quoted at TheStreet.com’s main site regarding the Fed. I think that the Fed is caught between a rock and a hard place, but I am not as pessimistic as this piece.

8 ) Finally, how do the actions of the Fed get viewed abroad?  Given the fall in the US Dollar, not nearly as favorably as the press coverage goes in the US.  Do I blame them? No.  They sense that they are losing economic value to the US, and that they are implicitly subsidizing us.  No wonder they complain.

Sometimes we forget how bad it can be, and then we howl over minor bad times in the markets. We may be past a mania in residential housing, but we have not really experienced a panic or crash yet. People squeal over how bad the equity market is, but recently we haven’t had anything like the 2000-2002 experience, much less the 1973-1974 or 1929-1932 experience.

Two books come to mind when I think about disaster in a non-fear-mongering way: Manias, Panics, and Crashes, by Charles Kindleberger, and Devil Take the Hindmost, by Edward Chancellor. They take two different approaches to the topic, and those approaches complement each othe, giving a fuller picture. Chancellor takes a historical approach, while Kindleberger deals with the structures of financial crises.

From Chancellor, you will see that manias and their subsequent fallout are endemic to Western culture. Someone living a full life over the last 300+ years would see one or two big ones, and numerous small ones. Relatively free societies give people freedom to make mistakes. Given the way that people chase performance, we can all make mistakes as a group, with large booms and busts. Much as the regulators might want to tame it, they can pretty much only affect what kind of crisis we get, and not whether we get one. He is somewhat prescient in suggesting that the leverage inherent in derivatives post-LTCM could be the next crisis. This book is a better one if you like the stories, and don’t want to dig into the theories.

But if you like trying to place the manias, panics, and crashes on a common grid, to see their similarities, Kindleberger has written the book for you. In it he draws on a number of common factors:

• Loose monetary policy
• People chase the performance of the speculative asset
• Speculators make fixed commitments buying the speculative asset
• The speculative asset’s price gets bid up to the point where it costs money to hold the positions
• A shock hits the system, a default occurs, or monetary policy starts contracting
• The system unwinds, and the price of the speculative asset falls leading to
• Insolvencies with those that borrowed to finance the assets
• A lender of last resort appears to end the cycle

I liked them both, but I am an economic history buff, and a bit of a wonk. The benefit of both books is that they will make you more aware of how financial crises come to be, and what the qualitative signs tend to manifest during the boom and bust phases of the overall speculation cycle.

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